After retirement, individuals typically rely on savings and investments to pay for day-to-day expenses since they lack a steady job-related income. One method of saving and/or generating wealth is investing in an annuity. An annuity is a savings or investment contract that makes payments, immediately, or at some deferred time in the future, to the beneficiary (the “annuitant”) of the contract, usually the individual that invested in the annuity, for the remainder of the individual's life. Some annuities allow the individual to save and/or grow money tax-deferred, taxing the gains at the time of disbursement. For post-retirement annuitants, deferring taxation is advantageous because the annuitant does not have an employment-derived income, typically falls into a lower tax bracket, and thus incurs a lower tax liability on the annuity payment. Two types of annuities are deferred annuities and immediate annuities. A deferred annuity begins making regular payments upon a certain date or event (e.g., upon the annuitant reaching age 65 or upon retirement). An immediate annuity begins making regular payments upon setting up the annuity or shortly thereafter (e.g., within a year). With an immediate annuity, the owner of the contract is, in a sense, buying an income stream. The money the contract owner buys the annuity with is pooled with the money of other contract owners, and their combined investments generate the money that will be used for annuity payments. Then at disbursement time, an annuitant is paid a certain amount as an annuity payment.
One aspect of determining annuity payments for an immediate annuity is the expected mortality of an annuitant. Mortality is an estimate of how long the individual will live based upon the individual's age, gender, and other factors. Because an annuity pays the annuitant for the rest of her life, the annuity provider determines the general amount of each annuity payment, how long annuity payments will likely be paid, and consequently the total amount paid to the annuitant over the course of the contract. For example, if a 76 year-old male has an estimated life expectancy of ten years, the amount per payment is calculated such that the initial purchase price of the annuity is sufficient to pay for annuity payments made over the course of those ten years.
Because annuity payments are made at regular intervals for the rest of the annuitant's life, if the annuitant lives past the estimated mortality date, and thus continues to receive annuity payments, the individual is getting more than the expected amount out of the annuity system; she is being paid more than she initially “invested” to buy into the income stream. Individuals that die before the estimated mortality date end up getting less out of the annuity system than expected and effectively pay for the payments of the individuals that lived past their expected mortality date.
Typically, money given to the annuity provider to purchase annuities is invested by the annuity provider to generate enough return that the annuity payments meet the income requirements of the annuitant's expected remaining lifespan as well as generate a surplus that goes to the annuity provider for administrative costs. The annuity provider guarantees certain annuity payments, so the annuity provider uses the purchase price of the annuity to invest in “safe” investments, such as money market funds and/or bonds, e.g., investments that are stable and predictable with respect to the rate of return.
In addition, or as an alternative to annuities, there is a product developed by FMR Corp., of Boston, Mass., that assists in saving for retirement. The product is a group of mutual funds called the Fidelity Freedom Funds® managed by Fidelity Investments. The Fidelity Freedom Funds® are mutual funds that have an asset allocation mix that includes domestic and international equity funds, investment-grade and high-yield fixed income funds, and short term investments like money market funds, Certificates of Deposit (CDs), or Treasury bills (T-bills).
The Fidelity Freedom Funds® are sometimes referred to as dynamic asset allocation funds because the asset allocation of the funds is changed over time by the fund managers. Geared towards saving for retirement, the Fidelity Freedom Funds® typically have an aggressive investment allocation when the investor is younger and seeks greater growth, and a more conservative allocation as the investor nears retirement, where the asset allocation shifts to a capital-preserving strategy. This is advantageous in that the Fidelity Freedom Funds® automatically change asset allocations based on the individual's stage of life as the individual approaches retirement. When the individual is younger, her portfolio is geared towards growth because the investor can tolerate more risk in the hopes of realizing a larger return. As the individual nears retirement, more and more of the money in her portfolio is moved to lower-risk, lower return investments and thus geared to principal retention. This typically ensures that the majority of the individual's money is available for retirement and is not as affected by contemporaneous swings in the stock market.